7th October 2015
Real estate fund managers often view legislation as either an opportunity or a threat - and the UK’s Minimum Energy Efficiency (Private Rented Property, England and Wales) Regulations are proving no exception.
Langham Hall recently heard of instances that demonstrate two sides of the same coin. In the first case, a large fund manager marketing for sale a London property encountered a buyer wishing to chip the price partly because of the property’s poor Energy Performance Certificate (EPC) rating.
In the second case, a fund manager negotiated down the purchase price of a £60m UK portfolio on the basis that the assets would be unlettable given the lowly EPC ratings. It won a £5 million discount from the seller who was oblivious to the fact that existing ratings attached to the assets could be incorrect. The buyer was able to have the ratings redone and achieve a higher rating at a fraction of the £5m it managed to haggle off the purchase price.
Both these instances stem from MEES, a piece of regulation for England and Wales that became law on 26th March 2015 following The Energy Act 2011. Member States were obliged to phase in such law in response to an EU Directive aimed at lowering Europe’s overall carbon footprint following commitments made under the Kyoto protocol.
Except for some exemptions, the regulations capture commercial properties owned by professional landlords including our real estate clients. The key is that from 1 April 2018, MEES makes it unlawful except in certain situations to grant a new lease or renew an existing lease for non domestic property if the property’s EPC rating falls below an E. Further, from 1 April 2023 it will be unlawful to continue to rent out a private rented property in scope of the regulation including when a lease is already in place and a property is occupied by a tenant.
If the EPC rating of a property should fall below an E, the landlord is required to make improvements to lift the property to the minimum standard unless the landlord can prove he is exempt, for instance by demonstrating necessary measures would reduce the value of the property by at least 5%, or that it would not be “cost-effective” under stipulated tests, or because he is unable to gain necessary consents.
Given MEES kicks into effect in less than three years, it is little wonder how topical it has become. Indeed, Nabarro highlighted it during a legal update seminar this week.
Just last month, Langham Hall also met with Miles Keeping, co-founder of London-based consultancy Hillbreak who flagged the regulation. He pointed out firstly that MEES was one of the few areas of legislation to survive the Conservative Party’s purge of green building-related laws.
Keeping, a former Head of Responsible Property Investment at Deloitte Real Estate and Head of Sustainability at GVA, went on to explain that given the new regulations, EPCs “posed a real risk” for asset managers, fund managers, institutional landlords and REITs.
EPCs are registered on a national data base and some 18 percent of properties on that database fall foul of the minimum E rating, according to estimates.
Keeping said he knew of an instance in which a property owner had almost 1,000 assets on the books, and had discovered that 21 percent of these had a sub standard rating. This represents a huge problem as the property owner risks losing £14.5m annually from a rent roll of £35m.
While the UK’s leading landlords seem on top of the issue, there is a huge, long tail of others that are not, according to Keeping.
He said some landlords were lumbered with G rated assets having had EPCs cheaply procured. Those managers fear they will be unable to let such assets without either improving the rating or investigating the quality of the certificates.
Managers are also facing another risk. Some savvy occupiers that have a break option in their lease are threatening to vacate knowing the landlord must lift the property out of a G rating which implies capital expenditure. That is triggering negotiations around new rental agreements. Lots of occupiers are now going into bat on that basis and less attractive new rental agreements are yet another way minimum energy efficiency standards can impact returns.
Even prime assets can fail minimum energy efficiency standards. New retail tenants might fit out the shell of the property with certain lighting provision that harms the EPC rating of the property, so it would be a mistake to assume that new build property would not be at risk of a low rating result.
Some owners do not even possess a complete picture of what EPCs they have in the portfolio because of incomplete records. The picture is further muddied for them because tenants have been able to gain an EPC for the property they occupy without the landlord's knowledge. This rating could be different to that of the owner.
Rachael Lyon, Langham Hall’s Head of Client Services, said the professional advice to property owners was to conduct a portfolio review including a review of all leases, assess the quality of the existing EPCs and contemplate utilising void periods and planned maintenance programmes for relevant improvements.
Keeping added having reviewed the portfolio, the second phase was to form a strategy having identified where capital expenditure would be necessary.
While some asset managers might claim they have a way to pass on costs of assessments to tenants, such a tactic might be on the margin of what might be considered reasonable or sharp practice, opined Keeping. “Instead, most asset management teams are taking it on the chin. They are going to re-risk the property,” he said.
If you would like to speak to Langham Hall about this or any aspect of real estate fund administration services, please contact Rachael Lyon.
Rachael Lyon, Head of Client Services
t: +44 (0) 20 3597 7934